The COVID-19 pandemic may add new impetus to European bank M&A. This topic has been on the agenda for many years due to the sector's persistent excess capacity and low structural profitability. However, despite these powerful catalysts for action, equally strong inhibitors have limited dealmaking to domestic consolidation within the most fragmented national markets (see European Bank M&A: More Talk Than Action, published on Aug. 6, 2018). S&P Global Ratings believes the economic disruption and low-for-even-longer interest rates triggered by COVID-19 may cause banks to see consolidation in a new light.

ECB Clarifies Its Approach To Evaluating Bank M&A

On July 1, 2020, the European Central Bank (ECB) published for consultation a draft guide setting out its supervisory approach to banking sector consolidation . The draft guide confirms that business combinations have potential to strengthen the soundness of the financial system. Banking supervisors rarely act as cheerleaders for consolidation: this is not their role, and the moral hazard risk is too great. Still, the ECB acknowledges that regulatory factors can make or break the business case for potential transactions, and its publication seeks to assure market participants that it will not impose unnecessary hurdles. Indeed, the ECB suggests it will apply a degree of flexibility and pragmatism in its approach to well-designed combinations that are positioned to meet prudential requirements on a sustainable basis.

Specifically, the ECB's draft guide clarifies its approach to three important points:

1.  The ECB confirms that the regulatory capital treatment of badwill (also known as negative goodwill) would follow the accounting approach, and therefore be positive for regulatory capital. This is a crucial consideration given the high likelihood that badwill would arise from M&A in the current environment, where most European banks' share prices languish well below their book values. We take a similar approach as the ECB in the calculation of our risk-adjusted capital ratio, and we reflect other transaction-related factors (such as synergy benefits and execution risks) in our business position and risk position assessments.

The ECB is understandably cautious over the balance sheet valuations underpinning badwill recognition. It expects such sums would be utilized in the business (such as covering integration costs) rather than distributed to shareholders, at least until the sustainability of the combined group's business model is "firmly established". The supervisory expectation of a sustainable business model is likely one that can operate through a full economic cycle with appropriate financial resources (including capital and liquidity) and controls.

2.  The ECB offers assurance that Pillar 2 capital buffers will not necessarily increase following a business combination. These requirements are a key determinant of the amount of capital that banks may need to raise in support of a planned transaction. The ECB states that its starting point will be the weighted average of the Pillar 2 levels applicable to the consolidating entities, and it will then adjust up or down based on its assessment of the combined group's resilience and risk profile. Since supervisors typically err on the side of caution, they may tend toward conservative buffers in the immediate aftermath of a merger or acquisition. However, the banking sector may welcome the ECB's clarification that, despite inherent execution risks, transactions can deliver risk diversification and cost synergies and thereby reduce business risk.

3.  The ECB states that it will apply a degree of flexibility to the use of internal capital models following a business combination. These models can be a hugely important determinant of an enlarged group's capital requirements because they generally produce lower risk-weights than the regulatory standardized approach. Supervisors grant model approvals to specific legal entities, and they are not normally applicable to newly acquired exposures or transferable to other entities. The ECB commits to avoid undue volatility in capital requirements by allowing combined banks to use the pre-transaction models for a limited period of time.

The ECB's intervention does not address certain other regulatory hurdles to consolidation, and it cannot do so alone. A particular barrier to cross-border integration is eurozone member states' requirements for banks to maintain separate national subsidiaries with ring-fenced capital, liquidity, and bail-in resources. Each country also has its own distinct bankruptcy laws and deposit guarantee scheme. Completion of the banking union would mean, among other things, that national markets would operate as a de facto single regulatory jurisdiction, which would support the business case for M&A.

Large-scale consolidation may produce more complex and interconnected banks that could face increased regulatory capital buffers for systemic importance. Authorities' too-big-to-fail concerns are unlikely to ease significantly at least until major banks take further steps to become truly resolvable.

COVID-19 May Spur European Bank Consolidation As Economies Recover

We see scope for increased European bank consolidation as economies recover from the current downturn. Most countries remain overbanked and COVID-19 effects exacerbate pressure on bank profitability by increasing credit losses and prolonging ultra-low interest rates. These structural weaknesses weighed on our assessment of several European banking systems when the pandemic broke out (see How COVID-19 Is Affecting Bank Ratings: June 2020 Update, published on June 11, 2020). Well-designed and well-executed integration is not easy to deliver, but could offer a solution by establishing fewer, larger banks with greater pricing power and improved cost efficiency.

There has been a trickle of European bank M&A in recent years, primarily domestic consolidation in countries including Italy and Spain. Intesa Sanpaolo's current offer for UBI Banca is a notable example. In the near term, the COVID-19 pandemic is likely to slow merger activity as banks focus on asset quality and operational stability. The inevitable rise in nonperforming assets and likelihood of further policy interventions add uncertainty to asset valuations and execution risks. To become more supportive of M&A, shareholders will likely need a clearer understanding of banks' paths out of the current downturn and their medium-term prospects as stand-alone entities. They will also need assurance on the capacity to achieve cost synergies in the years following a transaction. Under our base case of economic renewal in 2021, we expect European bank consolidation to re-emerge, particularly at the domestic level, and to do so with renewed vigor.

From our rating perspective, M&A is usually ratings-neutral at best for the acquirer or dominant merger partner on completion due to execution risks and because stronger banks often take over weaker rivals. Transactions can weaken creditworthiness if we conclude that they reduce the buyer's business stability, capitalization, or risk position. We typically see less risk in domestic deals than cross-border ones because we generally have more confidence in integration synergies, cultural fit, and the ability to manage regulatory and legal issues. M&A can support positive rating actions in the years following completion of a deal if it is well-managed and works to the benefit of creditors.

Related Research

• Asset Quality Not ECB Liquidity Will Determine Eurozone Banks' Fates, July 2, 2020
• Credit Conditions Europe: Curve Flattens, Recovery Unlocks, June 30, 2020
• Bank Regulatory Buffers Face Their First Usability Test, June 11, 2020
• How COVID-19 Is Affecting Bank Ratings: June 2020 Update, June 11, 2020
• How COVID-19 Risks Prompted European Bank Rating Actions, April 29, 2020
• European Bank M&A: More Talk Than Action, Aug. 6, 2018